Budgeting

Introduction#

How much money did you spend this week? What about this month? If you can't answer these questions, then you should make a budget. Contrary to popular belief, budgeting is not about depriving yourself of your morning Starbucks to save a few bucks. In this section, we'll talk about what budgeting is, why it's important, how you can start one, and some tools you can use to make sure you stay on track.

What is budgeting?#

Let's start with what budgeting is not. It is not about denying yourself happiness. It is not about spending as little money as possible. It is not just for people short on cash. These couldn't be further from the truth. Budgeting is all about planning your spending so you can enable yourself to achieve your financial goals. That sometimes might mean you have to make sacrifices here and there, but that doesn't mean you have to suffer and not reward yourself.

There are two main aspects to budgeting. First, you should be recording your expenses, either manually or with the help of a tool, so you know how much money you're using. Nowadays, it's so easy to lose track of how much money your spending because we're just swiping plastic cards or typing in some numbers as opposed to handing over cold, hard cash. You can't manage what you don't measure. Second, once you know how you're spending your money, you should set guidelines and goals and make adjustments to achieve those.

Why is budgeting important?#

Sure, everyone knows that budgeting is important, but when you see what you can do when you budget, you might appreciate it more.

Short-term expenses#

Food. Water. Shelter. Budgeting helps you afford the necessities. Sure that new phone looks sick, but is it worth missing this month's rent? You can make sure you have enough money every month to meet your needs. Pretty self-explanatory.

Long-term expenses#

Maybe you're looking to buy a house or get married or get a new car or go on vacation. Budgeting helps you plan for future expenses by saving money now. By comparing your income to your monthly expenses, you can see how much you have left to put towards these things and estimate when you'll be able to meet your goal.

Emergencies#

You get a flat tire. You get hospitalized. You lose your job. Unfortunate situations are bound to happen so why not plan for them? If you lose your main source of income or get hit with a giant bill, you want to have money reserved to help you get by. Budgeting lets you make sure you have an emergency fund to draw from.

Lifestyle planning#

Why do we spend 40 hours a week working a job? To make money, of course, but what use is all that money if you're not spending it how you want to spend it? Maybe you discover you're spending $500 a month on eating out when you've been wanting to eat healthy and workout more often. Maybe you discover you're spending $50 a month on random streaming services you don't really use, and you'd rather put that money toward your knitting hobby. Budgeting helps you know not just how much money you have but if you're spending it on things you want to spend it on.

How do I create a budget?#

When you're first starting out, it's okay to not have exact numbers. As you begin to record your income and expenses, you can get a better sense of how much you actually earn and spend to create a more accurate budget.

Some people budget annually, some budget monthly, and some even budget daily. I'd recommend creating a budget for the month because that's usually the time frame in which you can account for getting paid and paying important bills, but feel free to experiment. The best budget is the one you can stick to.

Step 1: Income#

First, you'll want to record your after-tax monthly income. Use pay stubs if you have them, but you can also use an after-tax income calculator to get an estimate.

If you have other sources of income like money from side hustles or dividends, you should also record it here. If you don't get paid in regular intervals (e.g. every two weeks or bimonthly) or you don't earn the same amount each period, you should estimate how much you make in the worst case and divide over the time period to find your average monthly income. For example, say you drive for Uber or Lyft every once in a while. During the past 6 months, you've earned $3000, but you know you've been driving more than usual lately. If you drove your normal schedule, you'd earn anywhere from $1800 to $2400 over 6 months. Take the lowest estimate and divide by the number of months to get how much you can expect each month in the worst case. So $1800 / 6 = $300 a month.

Step 2: Necessary Expenses#

Next, you'll want to account for things you have to pay for to survive. This may include things like:

Mortgage or rent
Utilities - electric, gas, water, sewer, internet
Groceries
Insurance
Transportation
Essential Toiletries

Some might consider Netflix or Spotify Premium a necessary expense, but don't include those here.

Step 3: Emergency Fund#

If you don't already have one already, or if you don't have 3 to 6 months of expenses saved up, you should put some money towards an emergency fund. An emergency fund is in case of, well, emergencies. Maybe you get laid off or you run into unexpected medical issues. If you already have this much saved, then feel free to skip this, but if you don't or you don't have the recommended amount put away, you should dedicate some money to this fund. You don't need to fill up your emergency in one lump sum, but the sooner you have this set aside, the more financially secure you will be.

Step 4: Debt#

Now, you'll want to allocate money to pay off any debts you have. If you don't have any, lucky you! If you do, no worries. Remember our conversation about interest? If you want to pay as little interest as possible, you'll want to make at least the minimum payment on all of your debts first. If you have additional money, you should put more money towards your debt.

There are a couple of strategies when it comes to deciding which of your debts to pay off first: the debt avalanche and the debt snowball methods. You can read about the differences here if you want a quick run down, but it essentially boils down to: if you want to pay less in total interest, use the avalanche method and pay off higher interest debts first, but if you tend to have trouble sticking to goals without a reward or want to improve your short-term cash flow (but pay more in total), consider the snowball method and pay off the lower interest debts first.

Step 5: Retirement#

Before the fun spending, you should save up for retirement. Sure, you might be young, but the longer your money is invested, the longer you can take advantage of compound interest. Let's say Person A invests $500 per month starting at age 25 until they retire at age 65. Let's say Person B invests $500 per month starting at age 35 until they retire at age 65. Assuming a 7% annual return¹, Person A is going to end up with $1,197,810. Person B is going to have $566,764. Would you rather be a millionaire or half a millionaire? You should allocate pre-tax or post-tax money towards your retirement, whether it be through a 401(k), an IRA, the Roth versions of those accounts, or something else.

Step 6: Goals#

Almost there, and now we're past the boring stuff, we can talk about the fun spending. Being financially responsible is cooler though. You'll want to consider any goals you have that would take significant savings to purchase. This could be a car, wedding, house, education, vacation, etc. Backpacking across Southeast Asia for a month sounds expensive, but if you save just $100 a month, you'll be on your way to Bali within a year. Plan ahead for these big purchases so you can chip away at them over a longer period of time.

Step 7: Discretionary Expenses#

Finally, anything that's left over you can put towards your fun expenses. Netflix, Spotify Premium, eating out, shopping, gifts, etc. You should be living within your means though and not purchasing things you can't afford.

Tools#

Great. Now how do you keep track of all that? There are tools and systems out there for you to use.

Software#

Using an app is probably the easiest way to go about all of this. Reducing the amount of friction it takes to budget really helps you stick to it.

The big names out there include Mint, Personal Capital, and You Need a Budget (YNAB). Mint and Personal Capital are free, but YNAB is a subscription service.

Another option here is Lunch Money which is also a subscription service. It's created by a solopreneur which is super cool!

Manual#

These are going to be a little more labor intensive, but maybe you don't like any of the software options or you want more control over everything.

Spreadsheets are a good way to keep track of everything. There are tons of templates out there to get you started too.

If you prefer using cash for payments, consider the envelope system. You label envelopes for your budget categories (e.g. shopping, groceries, gas, etc.), and put a budgeted amount of cash into each envelope. This can help you be more mindful about how much you're spending.

Returns are never guaranteed, but this is the average rate of return for the S&P 500 adjusted for inflation ↩